Toward a Long-Term (Multidecadal) Global Climate Change Derivatives Trading Facility

The potential of a Long-Term (multi-decadal) Global Climate Change Derivatives Trading Facility, to enable the trading of financial products related to long-term trends in the world’s climate, is explored.

Such an establishment is seen as enabling the transfer of climate change related financial risk via futures, options, and other insurance linked securities, and would represent a significant contribution to this area of risk management.

A review the various financial market products that are utilised to manage risk is presented in their various categories.

These include:

• The related areas of insurance linked securities and risk transfer instruments;
• The importance of the developing weather and climate derivatives industry; and,
• The potential application of these fields of knowledge to addressing the financial consequences of anthropogenic climate change.

A description of a ‘simulated’ trading platform, derived from numerical modelling of various processes involved in climate variability and change, is also presented, depicting how such a platform might operate in ‘real-time’.

A trading platform designed along these lines would lead to:

• The implementation of protection strategies, with their implications for future generations;
• The raising of capital for relevant ventures (such as for the generation of renewable energy);
• Speculation (of course), with the interesting side benefit – leading to the emergence of an unbiased consensus view about the future climate - on this subject, Little et al. (2015) somewhat bluntly suggest that parties “should either put up their capital ... or not”; and,
• Become an impetus to arousing interest in shifting the nature of the conversation about how best to manage financial aspects of climate change risk with a market-based approach.

Regarding financial market securities and bonds, and their potential application to ameliorating the impacts of climate change, the basic approach to addressing some of the financial consequences of global climate change is to regard measures of global climate variability and change in much the same manner as one would a financial commodity’s futures or options contract, and to value it accordingly.

It might be noted that regions of the world becoming unviable because of the impact of climate change are not restricted to poorer countries. This aspect has been explored by Sealey et al. (2018), regarding Miami (USA), and has been recently reported upon by Smee (2019), regarding Townsville (Australia).

The current author, in several papers, has explored the role of financial market instruments in the area of climate variability and change. For example, in a much earlier paper, Stern (1992) explored a methodology to assess the risk of climate change. Option pricing theory was used to evaluate securities in terms of the risk faced (both risk on a global scale, and risk on a company specific scale).

One application given was that of the cost of protecting against diminished industrial output because of global warming. Another application was protecting against decreased value of a manufacturer of ski equipment because of warming.

It was suggested that such securities could be used to help firms hedge against risk related to climate change. The cost of a call option contract on the value of a Futures Global Mean Temperature (GMT) contract was calculated. In determining the cost, the volatility of the GMT, calculated over 130 years of data, was applied.

With the emergence of very long-term maturity (100-year) bonds, the author updated previous work to establish theoretical ‘fair value’ premiums (costs) for sets of call and put options about futures contracts related to the annual value of the GMT.

Both the call and put options were said to have been purchased at the end of 2018, with a strike of 15.0°C, and possessing a premium (value) of $100 per °C upon expiry.

Theoretical ‘fair value’ prices of call options on GMT futures set to expire on Dec-31 in each year out to 2100 are depicted in the upper image (from Stern, 2019). The lower image is an illustration of how an online climate change trading facility page might appear.

Subsequent to the American Meteorological Society’s Annual Meeting in Phoenix, the author attended the Insurance Linked Securities (ILS) conference, held on Friday, February 1st in New York, under the auspices of the Artemis organisation (Artemis, 2019). The Red Cross and Red Crescent Societies hosted a side-event the day before the ILS conference, on Thursday January 31st, 2019, on the future of humanitarian aid, titled: Risk Transfer Instruments - Innovations in Refugee & Migrant Financing. This has relevance in the context of the likely future impact of rising sea levels on the viability of several very low-lying south west Pacific Ocean islands.

Finally, and most importantly, a discussion is presented about how best to implement the proposed Long-term (multi-decadal) Global Climate Change Derivatives Trading Facility. This is done in the context of an examination of the different types of trading platforms, and how it is perceived the proposed exchange may fit in. This then leads to the outcome most desired, namely, to see the establishment of such a facility to enable the trading of financial products related to long-term trends in the world’s climate.

References:

Artemis 2019 ILS New York 2019 Unlocking the next phase of ILS growth. 1 February 2019. Programme.

Little L R Hobday A J Parslow J Davies C R and Grafton R Q 2015 Funding climate adaptation strategies with climate derivatives. Climate Risk Management 8, 9–15.

Sealey K S Burch R K and Binder P M 2018 Will Miami survive? The dynamic interplay between floods and finance. Springer Briefs in Geography, 75 pp.

Smee B 2019 Townsville homes may become uninsurable due to flooding from climate change. https://www.theguardian.com/australianews/2019/feb/20/townsville-homes-may-becomeuninsurable-due-to-flooding-from-climate-change?

Stern H 1992 The likelihood of climate change: a methodology to assess the risk and the appropriate defence. Preprints, 5th Int. Meeting on Statistical Climatology, June 22-26, 1992, Toronto, Canada, Amer. Meteor. Soc.

Stern H 2019 Pricing financial market instruments to protect against, and to speculate about, climate change - an update. 10th Conf. on Weather, Climate, and the New Energy Economy, Phoenix, AZ, 6-10 Jan. 2019, Amer. Meteor. Soc.